A New Approach to Decontrol of Oil Prices

March 27, 1979

The government faces a hard choice in its energy policy.Most economists and energy experts have been urging decontrol of oil prices as an essential step for minimizing our dependence on oil imports. Some economists, myself included, have been urging a gradualist approach to decontrol as an important element in the anti-inflation fight.

Now the disruption of oil supplies from Iran and the worsening of price inflation in recent months have increased the urgency of both arguments. And an emerging shortage of unleaded gasoline, apparently a byproduct of present controls, has added to the pressure to alter or eliminate the controls system.

The plan I am presenting offers a new approach to dealing with these problems. It provides virtually all the benefits of complete decontrol of oil prices at only one-third of the inflationary cost that decontrol would normally entail. It encourages the production and use of unleaded gasoline. And it even promises a small net gain in government revenues.

The two key features of the plan that permit there impovements are a severance tax -- a flat tax per barrel as it flows out of the well -- on all oil production in the lower 48 states, and the appropriate use of the revenues from that tax.

The plan has four parts. No one can say where the world price of oil is going over the next couple of years. But to get some idea of the economic effects of this plan, let's begin with the reasonable guess that the world price will rise 25 percent from 1978 to 1980.

First, under the plan, all price controls on crude oil and its products would be removed, bringing the price of all U.S. crude oil to the world level. With a 25 percent increase in world oil prices, even with domestic controls maintained, the average price of all oil (including imported products) used in the United States would rise by $2,85 a barrel over this interval. With complete decontrol, that average price would rise by an additional $2.30.

Sceond, a severance tax of $3 a barrel would be applied to all crude-oil production except that from Alaska. This brings in $8.3 billion a year at present production levels. The tax would not change the average price under decontrol since that is set by the world market. It would recoup over half of the gross revenues to the oil industry that would result from decontrol.

Together with existing profits taxes, nearly three-fourths of the added revenue would be taxed, or a total of $11.1 billion. This increment to federal tax collections would be used to finance the two remaining parts of the plan that would minimize the inflationary impact of decontrol.

I exclude Alaskan oil from the severance tax for two reasons. Shipping costs of Alaskan oil are very high, resulting in a net price at the wellhead of only $5 to $6 a barrel in 1978. Also, Alaska is the most promising source for expanded domestic production in the next few years. A substantial increase in the net price will encourage that expansion.

Third, present excise taxes used to finance the highway trust fund would be eliminated, thus removing $7.5 billion of taxes from the price level. That amount would be earmaked for the highway trust fund from the severance-tax receipts. Most of the highway trust funds at present come from the federal excise tax on gasoline and diesel fuel with the rest coming from excise taxes on other highway-related products such as trucks, tires and lubricating oils.

Changing the source of financing of the highway trust fund will reduce the average price level because these taxes now raise prices while the proposed severance tax has no impact on the price level.

Fourth, a payment of 5 cents a gallon is made to refiners for all unleaded gasoline produced. With all prices decontrolled, the fuel subsidy will show up as a lower price than would otherwise prevail.

When half of the gasoline produced is unleaded, which might happen by 1980, payments would be $2.1 billion. This still leaves a net budgetary surplus from the plan: added revenues of $11.1 billion against the price-reducing costs of $7.5 billion for excise-tax elimination and $2.1 billion for the unleaded gasoline payments.

Under the assumed world oil-price rise of 25 percent between 1978 and 1980, oil prices will add almost 0.8 percent to the GNP price deflator, even with present controls maintained. Under the plan, the impact on the GNP price deflator will be 1 percent, less than a quarter of a percentage point more. By linking decontrol to the severance tax and the price-reducing measures that it finances, the plan achieves the simplicity and supply incentives of decontrol with a relatively small inflationary push to the overally price level.

It is impossible to project with any confidence the size of the effects on oil supply that will be forthcoming from price decontrol under the plan. It will remove the enormous temptation that now exists to reduce output from pricecontrolled fields to qualify them for uncontrolled stripper status -- strippers being wells from fields that produce an average of less than 15 barrels a day. Decontrol may also expand production from controlled fields if it is now being restrained in anticipation of decontrol. And eventually it will encourage enhanced production from the use of expensive recovery methods. These supply effects may or may not turn out to be important; but the plan does provide virtually all the supply incentives that are available from decontrol alone.

In eliminating price controls, the plan eliminates the present entitulements system, which invites inefficiencies, requires a cumbersome bureaucracy and may foster sharp practices or even dishonesty in the oil business.

By encouraging the production of unleaded fuel and its use in place of leaded gasoline, the plan meshes perfectly with our environmental concerns.

Finally, the plan reduces the profits windfall that would accrue to some oil producers as a consequence of decontrol and to other producers, who are already decontrolled, as a consequence of another sharp rise in world oil prices. It does result in some increase in the net price to all producers under currently forseeable world oil prices.